Macro

In case you were wondering whether to sell all those boring defensive highly indebted infrastructure, utility and REIT stocks, look at these charts of the US, Australian and Euro 10 year bond yields. Don’t sell yet it seems. Interest rates are falling globally, they have been cut here twice, will be cut again this month in the US, and the appointment of Christine Lagarde to the ECB is being interpreted as meaning European central banks will remain dovish as well. As you can see European 10 year bond yields are in negative territory and at record lows – in 1980 I could have got odds of a million to one on a bet that a central bank official rate would one day go below zero.

Bond yields are hitting fresh multi-year lows globally which, if you ignore the short-term sugar hit for equity valuations from that trend (from using a lower discount rate in DCF valuations), there sits a clear message that the global economy is slowing. And central banks are clearly still behind the curve - market rates are ahead of official rates – so rates will only go lower from here.

These lower interest rates are proving to be a powerful driver for equities, which is somewhat counter-intuitive. Bad news is good news. Good news for now but you have to wonder whether at some point the herd won’t turn its attention to the reason why they are falling. Growth. No one seems too fussed at the moment. The S&P 500 just hit another all-time high.

I am entirely sure that at some point in the future the herd is going to sober up. But for now, we are running with very low cash levels in our portfolios and are effectively fully invested with our necks stuck out in a few places in growth stocks.

But we are not selling. The market can defy logic for long periods and experience tells me that “chickens don’t make money”. There is just no point being smarter than everybody else and selling before the herd wakes up. Even the central banks, who are paid to be cautious and are always the first chickens to start handing out warnings and wag their fingers at risk takers, have yet to express concern. And Trump certainly won’t. His ego and election chances rely on the opposite, on the impression of economic and financial market success.

The most famous example of central bank caution was Greenspan’s warning on December 5, 1996 – at the time the US stock market had gone up 65% in two years – circumstances were a bit similar – Greenspan had, in 1994 preemptively raised interest rates to head off inflation before it happened which turned central bank policy on its head. Up until then, the Federal Reserve, and every other central bank, was in the habit of raising interest rates as a reaction to higher inflation. They were always behind the curve, and the net result had been decades of highly volatile inflation and interest rates.

By preemptively raising rates Greenspan got ahead of the inflation curve and effectively killed it launching decades of falling inflation and falling interest rates which continues today as you can see in the bond yield charts above. As inflation fell and interest rate certainty descended on the markets for the first time in history, the stock market boomed leading to his famous warning:

Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?

On the day he made this comment, the Japanese market was open, and it dipped 3% before the close followed by the other markets the next day. But that was it. In the next three years, the S&P 500 rallied another 105% taking it up 241% in the five years prior to the tech boom going bust.

Greenspan was right in hindsight, super negative commentators (Faber, Dent, Roubini) always end up being right one day, but it is of little value to investors, to people like us who want financial security in the long-term, if their timing is off. Greenspan was over three years too early.

The interesting thing today is that the central banks, the biggest chickens, have hardly squawked about the threats to the global economy and certainly haven’t stepped on the toes of the equity market by making any noises about share prices and the stock market.

About as worrying as it’s got has been the RBA making it clear this week that the government needs to pitch in as well, with fiscal policy, because they are running out of gas. But the RBA have still come up short of making any comment about any deep felt economic concerns. Meanwhile, the barometer of central bank concern, interest rates, are flashing red. In fact, in Europe, they are actually in the red.

And it is clear that the end of this growth deterioration is far from over. The FOMC are 100% likely to cut rates on July 31 with two or three more rate cuts factored in by the bond market before December, and the RBA are making the same noises that Europe has been making since the GFC, which is that they will move rates as appropriate. The ECB has even made it clear that they are also prepared to resort to quantitative easing again to sustain growth, and the RBA have surprisingly hinted at it as well in their last meeting.

The FOMC will lead on the “Chicken Narrative”, but they have gone mute, at the moment they are clearly highly intimidated by their President who openly accuses them of stifling growth with high interest rates (you call 2.25% interest rates high?!).

The bottom line is that nobody, not even the biggest chickens, the central banks who are paid to be cautious and traditionally the first to point the finger at the King with no clothes (an overpriced stock-market) have yet to say anything meaningful about the economic risks ahead or the price of assets.

And if the central banks aren’t prepared to express any deep-seated concerns we are years away from any other canaries in the mine following suit, which, in order, includes, hedge fund managers (the too smart ones who sell first and then try to get everyone else to do the same), the sensible boutique fund managers who care about the fortunes of their investors, the big institutional strategists (the ones you see on TV), the media (who regurgitate the strategists and get more clicks using fear), the taxi drivers (always one step ahead of the brokers), then the brokers (for whom being negative kills revenue, commission and deals - optimism is their life blood).

The last people to wake up to the market risk, and may even sleep through the whole thing, are the biggest domestic fund managers (big industry funds and Super funds) who only judge themselves relative to the market and if the market falls over so what, as long as they don’t massively depart from the index – and anyway, these days, thanks to the wonders of the interweb and the millions of dollars they spent on their websites, they have left the asset allocation up to you, their individual members.

Absent central banks expressing themselves openly, this market can keep going and who are we to argue with that. So I, with $45m of other people’s money to look after, wait for the top, and am not going to be so smart/stupid as to predict it before it happens. As always.

And anyway, if Greenspan is anything to go by, when the central banks get up the guts to tell us they are worried about asset prices, we have another three years of the bull market to go!

When you do start to get cautious on growth the obvious move is to cash up for us, but for the ‘relative performance’ based fund managers the clear strategy will be to rotate into the boring defensive interest rate sensitive stocks that do well when interest rates fall – utilities, infrastructure, REITs – oh, and for anyone trying to make money, buy gold stocks…. Gold traders love a crisis.

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Marcus Padley is the author of the Marcus Today stock market newsletter. To sign up for a 14-day free trial please click here.



Comments

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Tony Mola

Excellent article by Marcus Padley, as usual. Tony

Stephen Cocker

Fantastic piece Marcus, for straight forward commonsense thinking you are the best in the business. Steve Cocker.

jerome fernandez

love the way you dont shy away at having a crack at people in your own profession.. im already looking at gold . Reits can wait